Research Affiliates: A Preference For Discomfort

March 20, 2014

A disciplined contrarian approach is likely to result in more wealth over time than the alternatives.

Yikes is right! Investors continue to underperform the market by a significant margin, as Russ Kinnel of Morningstar reminds us in his 2014 version of “Mind the Gap.”1 While many theories try to explain this persistent underperformance, I will focus on one: Too many of today’s commentators seem not to notice that our knowledge of investment markets has progressed well beyond the theories of the 1960s.

Today, too many cling to the simple to understand but thoroughly refuted theory of a single market beta. Too many misinterpret today’s ongoing debate about market efficiency as supporting the long abandoned theory that all investors should hold an identical portfolio. Too many misinterpret the sound guidance from experts advising individual investors to buy and hold low cost index funds as proof that earning above market returns is unattainable.

To be sure, well-informed and well-intentioned commentators including Jack Bogle, David Swensen, and Warren Buffett who advise investors to buy and hold the market, in the form of a low cost index fund are correct. Ample empirical evidence convincingly demonstrates that following such advice would allow the vast majority of investors to dramatically improve their wealth accumulation, likely by a few percentage points per year. But our present understanding of financial markets is more interesting than this conclusion, as correct and as important as it is.

A more current understanding of financial market theory and evidence helps us understand why so many investors choose to behave in ways that produce lower-than-market returns. We now understand not just that these investors could improve their returns by indexing, but also why they don’t, and reciprocally why those who are willing and able to behave in a contrarian manner can and do earn market-beating returns.2

Evolution Of Finance Theory

Theories developed in the 1950s and 1960s provide the foundation of our current understanding of financial markets. Harry Markowitz introduced modern portfolio theory (MPT) with his study of portfolio selection, mean variance optimization, and the efficient frontier in 1952. In the early 1960s, building on Harry’s work, Jack Treynor and Bill Sharpe developed the capital asset pricing model (CAPM), predicting that security returns are explained by a single market beta. Also during the 1960s, Gene Fama developed the efficient market hypothesis (EMH).

In the 1970s and 1980s we learned that the single equity market beta prediction of the CAPM was, at best, incomplete. In 1976, Stephen Ross proposed the Arbitrage Pricing Theory (APT), introducing an asset pricing model with multiple factors determining the returns of individual securities. In the 1980s Ross, Roll, and Chen published convincing evidence that security returns are determined by multiple factors.

The very fact that the CAPM could be disproved demonstrated the revolutionary nature of the insights of MPT and the CAPM. A field of study is not science unless it produces falsifiable theories. Moving on from the CAPM to APT demonstrated important scientific progress in our study of markets. Oddly, three decades after APT, the disproved single equity market beta prediction of the CAPM remains the dominant pricing theory taught in many business schools.



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